Setting Sail on a Journey of Transparency

As my birthday is November 4, I am an expert on the 4 November Marketing Rule.

The SEC's November 4 Marketing Rule aims to increase transparency and accountability in the hedge fund industry by requiring hedge funds to provide more information about their strategies, performance, and fees in their marketing materials. The rule also requires hedge funds to disclose any conflicts of interest arising from their marketing activities.

Why The SEC Adopted the Marketing Rule Now

Since the adoption of the Advertising Rule and Cash Solicitation Rule in the early 1960s and late 1970s, an era that predated the internet and personal computers, advertising and referral practices have evolved.

Simultaneously, the technology used for these communications has advanced, the nature and profiles of the advisers in the investment advisory industry have diversified, and the expectations and types of investors shopping for advisory services have changed.

For example, the internet, mobile applications, and social media have become integral to business communications.

As such, investors have come to rely on these forms of communication to obtain information, including reviews and referrals, when considering which advising services to elect.

Charting the Key Provisions

Strategy Disclosure

Hedge funds must provide detailed information about their strategies, including any associated risks.

Prohibition on Hypothetical/Simulated Performance

Hedge funds may no longer use performance data from hypothetical or simulated accounts in marketing materials.

Conflict of Interest Disclosure

Hedge funds must disclose any conflicts of interest arising from their marketing activities, such as compensation arrangements with third parties.

Net/GrossPerformance Presentation

Hedge funds must present net performance with equal prominence as gross performance when showing the performance of a single investment or group of investments ina private fund.

Case Study and "Cherry-picking" Restriction

Hedge funds must present all associated portfolios with some exceptions, or a composite meeting specific stated criteria.

Hypothetical Performance Restriction

Hedge funds may no longer present hypothetical performance, including model performance, backtested performance, target or projected returns, and performance extracted from multiple portfolios.

Predecessor Performance Restriction

Hedge funds may no longer show the past track record of a predecessor adviser.

The key takeaways from the November 4 marketing rule provisions

One of the main provisions of the November 4 Marketing Rule is the requirement for hedge funds to provide detailed information about their strategies, including any significant risks associated.

This can be seen as a challenge, but it also presents an opportunity for hedge funds to demonstrate their expertise and knowledge of their strategies to potential investors. By providing clear and comprehensive information, hedge funds can set themselves apart and show their commitment to transparency.

Another key provision of the rule is the prohibition of using performance data from hypothetical or simulated accounts in marketing materials.

This may have been a common practice, but it is no longer an option under the new rule. Hedge funds must find new ways to demonstrate their track record and performance.

The November 4 Marketing Rule also requires hedge funds to disclose any conflicts of interest arising from their marketing activities, such as compensation arrangements with third parties.

This can be seen as an additional compliance burden, but it also provides an opportunity for hedge funds to demonstrate their integrity and commitment to ethical practices.

By being transparent about potential conflicts of interest, hedge funds can build trust with potential investors.

In addition, the SEC staff has issued an FAQ related to the Marketing Rule clarifying that the net/gross rules apply to the extracted performance that may consist of returns of single investments.

This addresses one of the many ambiguities of the Marketing Rule, which has been in effect since November 4, 2022.

Performance Presentation Requirements

Asset Managers and Hedge Funds should be aware, in particular, of the Marketing Rules' requirements in connection with how certain types of performance are shown in any advertisement.

The following is a high-level summary of the types of performance that will require new, updated or enhanced disclosures by funds and their advisers:

• The requirement to show net performance with the gross performance
• Case studies and "cherry-picking"
• Related performance – the requirement to show all associated portfolios with some exceptions or a composite meeting specific stated criteria.
• Extracted performance – prohibition on showing a subset of investments in a portfolio unless the adviser shows, or offers to provide promptly, the performance of the entire portfolio
• Hypothetical performance – includes (1) model performance, (2) backtested performance, (3) target or projected returns and (4) performance extracted from multiple portfolios.
• Predecessor performance – showing the past track record of a predecessor adviser or personnel while employed by a predecessor adviser

The Marketing Rule also impacts testimonials and endorsements in advertising materials. Investment advisers must now disclose any compensation arrangements with third parties who provide testimonials or endorsements. This includes both cash and non-cash compensation.

Additionally, advisers must ensure that any testimonials or endorsements they use are not misleading and represent the experience of a typical client.

Another critical aspect of the Marketing Rule is prohibiting third-party ratings in advertising materials without disclosing certain information about the rating agency and the rating itself.

This includes disclosing compensation arrangements between the rating agency and the investment adviser.

Finally, the Marketing Rule includes new books, records requirements and updates to Form ADV. Advisers must keep records of all advertising materials for at least five years and file any advertisements with the SEC within one month of first use.

Impact on Hedge Funds

The November 4 Marketing Rule will likely make it more difficult for hedge funds to attract new investors, as they will have to provide more information and be more transparent about their performance.

However, by embracing the new requirements and differentiating themselves through high-quality, detailed information and a strong track record, hedge funds can continue to attract potential investors.

The rule may also lead to increased compliance costs for hedge funds, but these costs can be mitigated by taking a proactive approach to compliance and seeking the guidance of legal counsel.

Hedge funds should review their marketing materials and strategies to comply with the new rule.

This includes providing detailed information about their strategies, performance, and fees and disclosing any conflicts of interest arising from their marketing activities.

To differentiate themselves, hedge funds need to focus on the main marketing trends, while building a robust marketing strategy to demonstrate a strong track record of performance to potential investors. They can also consider hiring legal counsel to ensure compliance with the new rule.

The new Marketing Rule also has the potential to impose additional compliance burdens on hedge funds, particularly in light of the recent news that the SEC Staff has updated their FAQs for the Marketing Rule.

Updated FAQ's from January 2023

The new FAQ imposes the net performance presentation requirement at the investment level, which may present significant challenges for hedge funds in calculating and presenting net performance information of individual investments that satisfy the tailored disclosure requirements.

This could result in the need for an estimated or model fee, which would create separate disclosure issues to prevent the presentation from being misleading.

In light of the potential impact of the Marketing Rule on hedge funds, they need to review and update their current marketing practices and strategies to ensure compliance with the rule by November 4, 2022.

This includes updating or revising their marketing materials, written policies, procedures, and systems to ensure they are reasonably designed to prevent violations of the Marketing Rule by the advisers and their supervised persons.

Furthermore, as amended, as the Books and Records rule will require investment advisers to make and keep certain records, such as records of all advertisements they disseminate, hedge funds may need to update their firm's policies and retention systems to incorporate these added requirements.

However, they present complex new challenges for those in the organisation tasked with maintaining compliance, security and data privacy. From recording and retrieving records of communications to protecting sensitive conversations in new channels, there are significant issues to manage in this new paradigm.

History has repeatedly shown that mistakes, breaches and data exposure happen when people communicate and share information digitally.

The limitations of legacy supervision and archiving approaches make the need to effectively mitigate these risks all the more complex, which pose real risks and costs to businesses.

At the same time, regulators expect the same robust controls regardless of where staff work. In financial services, the fines levied this year for failure to capture, retain and supervise communications exceed $2 billion.

This crackdown on non-compliant communications is the clearest indicator yet that regulators have lost patience with firms that still need to address supervision and record-keeping risks exacerbated by the pandemic.

The November 4 Marketing Rule presents new challenges for hedge funds and opportunities for differentiation and showcasing their unique strengths to potential investors.

By understanding the rule's purpose and key provisions and implementing best practices for compliance, hedge funds can navigate the new restrictions and continue to attract potential investors.

The SEC's staff has also issued an FAQ related to the rule, which clarifies the application of the net/gross rules to extracted performance. It also highlights the need for hedge funds to disclose the methodology used to calculate net performance and to be aware of other provisions in the rule that may prohibit misleading performance data.

As the industry continues to adapt to the new rule, hedge funds need to stay informed and work with legal and compliance professionals to ensure compliance and capitalise on the opportunities presented by the rule.

Disclaimer: The information provided here is for general informational purposes only and is not intended as legal advice. It is always recommended to seek advice from a legal counsel before making any decisions.